Do you often get confused about the Periodic Inventory System? In this article, we will understand what the Periodic Inventory system is and how it differs from Perpetual Inventory System.
Let us first start with the basics of the periodic inventory system. It is an inventory management system that gets updated at a specific period, unlike the perpetual inventory system, a real-time inventory management system.
The Periodic Inventory System differs from the perpetual inventory system, as this system does not give real-time updates of the stocks. The periodic system gets updated only through the physical entries made in the ledger, which is not automated.
What is periodic inventory system?
As discussed above the Periodic Inventory System is an inventory management system that keeps the record of stocks at a particular time interval through the physical inventory count method.
With the physical inventory count method, this system helps to update the stock report in the ledger at the end of a particular time interval, which has a specific advantage in itself.
These physical counts are done either quarterly or yearly depending upon the inward-outward projections or the organization’s policies. Hence this system shows the inventory or stock count shows the cost of inventory which was recorded a quarter earlier, depending on the physical count taken.
In this system, the stock count is recorded at the beginning of a period decided. The new purchases or transactions are added during the period and later at the end of the said period, deduction of the final of ending stocks is done to get the Cost of Goods Sold (COGS).
Understanding Periodic Inventory System
So far we came to know the basic things about the Periodic Inventory system and the method through which it is operated. Now it’s time to understand the actual process of this inventory management system.
In this system, all the purchases made during physical counts get recorded in the purchase account. When the count is done the said balance is added to the inventory count. Which is then added to the cost of the ending inventory figure.
Cost of Goods Sold
Cost of Goods Sold is the direct cost of producing the goods sold by a company. This includes the cost of labour and raw material which is directly used to produce the said goods. The COGS does not include indirect expenses like distribution and sales force costs.
Cost of Goods Sold is calculated as follows-
Beginning Inventory + Purchases=Cost of Goods Available for sale
Cost of Goods Available for sale – Ending Inventory = Cost of Goods Sold (COGS)
Let us understand through an example –
Let us assume a company that has starting inventory of ₹10 lakh. Out of which the said company had purchases worth ₹17 lakhs, and the physical inventory count shows the inventory cost of ₹80, 000. Then the COGS is calculated as follows –
100000 (beginning inventory) + 170000 (purchase) = 270000(Cost of goods available for sale)
270000 (Cost of goods available for sale) – 80000(Ending Inventory) = 190000 (COGS)
So, the said company has ₹1,90,000 of Costs of Goods Sold (COGS)
Advantages & Disadvantages of Periodic Inventory System
The Periodic Inventory System is mostly useful for small businesses to maintain their inventory consisting of small amounts.
For such small businesses, it becomes easy to count the physical inventory with this system which could help to estimate the Cost of Goods Sold figures for the said period.
As this is a physical count method, it has more limitations than benefits. Here are some of the limitations of this system:
Minimal Information – with the Periodic Inventory system, it is very difficult to get information about the cost of goods sold (COGS) or the inventory balances during the interim periods when there are no physical counts or transactions.
Estimation Errors – as this system lacks in giving real-time updates of the stock transactions, it causes some estimation errors in calculating the COGS.
Large Adjustments – it is very difficult to adjust the inventory losses during the interim periods. Hence, when the physical inventory count is completed, it requires a lot of adjustments for covering those mid-period losses.
Not Scalable – as we discussed, that the periodic inventory system is most suited for small businesses, due to the limitations discussed above. It is relatively hard to scale this system for large companies having large inventories and stock transactions.
Hence the Periodic Inventory System is only used in small and medium-sized enterprises (SME’s), which don’t have to deal with a large inventory for their business.
Also, you must read about the Perpetual Inventory System and its benefits over the periodic inventory system.